4Q:2018 Quarterly Update – Investor Worries Overwhelmed Fundamentals


Investor worries overwhelmed fundamentals. A combination of worrisome factors—any one or two of which would normally be sufficient—drove stocks downward during the fourth quarter.

  • The US trade war with China persisted.
  • Global economic growth decelerated, particularly in China, sparking fears of corporate earnings declines, supply chain disruption and, potentially, a US recession.
  • The Fed raised interest rates in December for the fourth time in 2018 and indicated that it would keep hiking, leading many investors to question whether the Fed fully grasped the potential implications of both its rate-tightening and balance-sheet reductions on the US economy.
  • Oil prices fell, reflecting concern about softening global economic activity.
  • Political turmoil rocked the US and culminated in a partial federal government shutdown, while Europe dealt with Brexit-related uncertainty and tension over Italy’s proposed spending and debt levels.
  • Technical factors such as trading by algorithm-based investors and exchange-traded funds, as well as tax-loss trading, exacerbated selling momentum in the last weeks of the year.

For stocks, the worst performance in a decade. Stocks retreated as sentiment shifted from tempered optimism to anxiety that earnings growth would evaporate.

  • On a total return basis, the S&P 500 returned -13.5% in Q4 and -4.4% in 2018, its worst such performances since Q4 2008 and 2008, respectively.
  • The Q4 decline was large enough that 2018 was the first year in which the S&P 500 posted an annual loss after rising in the first three quarters.
  • Large caps outperformed mid caps and small caps for the quarter and year.
  • As measured by the Russell 2000 Total Return Index, small caps registered their biggest respective quarterly and annual losses (-20.2% and -11.0%) since Q3 2011 and 2008.

Bonds benefited from flight to quality. Even as the Fed raised benchmark interest rates and reiterated its intention to keep doing so, investors sought safe-haven Treasuries. The 10-year Treasury yield closed at 2.68%, down 37 basis points during the quarter.

  • The high-quality Bloomberg Barclays US Aggregate Bond Index gained 1.6% and 0.01% in the quarter and year. The Bloomberg Barclays US Corporate High-Yield Bond Index lost 4.5% and 2.1%, respectively.

Convertibles lost ground. Not surprisingly, convertibles fared better than stocks due to their bond-like characteristics but worse than bonds because of weakness in their underlying equities. The Thompson Reuters All Cap Focus Convertible Index returned -7.5% in the quarter and -0.1% in the year.

Our strategies generally underperformed (see page 4 of pdf). Although we had adjusted our portfolios to weather a downturn, all of our strategy composites generated negative quarterly returns, and most did so for the year as a whole. Healthcare Opportunities and Convertible Arbitrage achieved annual returns that were both positive and significantly higher than those of their respective benchmarks.


Mixed picture portends a challenging year. The factors that sent investors to the exits in the fourth quarter remain the primary market risks as 2019 begins. Concerns about global growth rose after Apple reduced its Q4 revenue forecast in early January due to slowing iPhone sales in China—exacerbating fears that the Chinese economy is slowing down.

That said, we also see significant positives that could support a stronger market environment:

  • While fundamentals aren’t as favorable as in 2018, they’re hardly disastrous.
  • Credit markets aren’t signaling recession: While high-yield spreads have widened, they aren’t close to historical peaks.
  • According to FactSet, consensus forecasts for S&P 500 earnings and revenue growth in 2019 are 6.9% and 5.5%, respectively. To be sure, these numbers are meaningfully lower than those in 2018 and 2017, but they’re also much higher than those in 2012–2016—when the S&P 500 posted solid gains in all but one year (2015).
  • Valuations are more reasonable. The S&P 500’s 12-month forward P/E ratio is around 15x (per FactSet), down from 16.8x at the start of the fourth quarter.
  • The drop in bond yields makes stocks look more attractive by comparison: At a 15x forward P/E, the S&P 500 earnings yield is 6.7%, almost triple the 10-year Treasury yield of around 2.6%.

A strong December US jobs report—312,000 jobs were added, nearly double what economists had predicted—suggests that the US economy hasn’t lost steam.

It’s all about trade, rates and confidence. We believe that the economy’s directional movement ultimately will be driven by what happens with regard to three factors: trade, interest rates and investor confidence.

  • Trade. As we write, the US and China have entered a 90-day window to negotiate a resolution of their tariff war. Investors would welcome an agreement that ends tariffs or at least provides for greater certainty, and likely reject anything less.
  • Rates. The question here is whether the Fed remains on autopilot and will continue to reflexively tighten, or takes a more flexible data-driven approach. In recent remarks, Chairman Powell emphasized that the Fed’s monetary stance would be “patient” going forward. Markets would react enthusiastically if the Fed’s actions align with these comments.

Confidence. The December Conference Board Consumer Confidence Index® results reflected a cacophony of crosswinds in which respondents felt good about the present but concerned about the future. Business confidence surveys were incrementally more pessimistic. Investors would like to see these sentiments reverse course.

Bifurcated outcome. We expect market activity in 2019 to follow either of two most probable scenarios, and are hopeful that conditions will become clearer as companies report fourth-quarter earnings over the next few weeks.

  • In the negative scenario, the earnings outlook deteriorates if the trade situation doesn’t show meaningful progress; the Chinese economy continues to decelerate; the Fed keeps hiking; and confidence doesn’t recover. Large caps would likely outperform in this case.
  • The positive scenario is the opposite: The earnings outlook improves if there’s greater clarity on trade; the Chinese economy picks up; the Fed adopts a more accommodative approach both to rates and its balance sheet; and confidence recovers. Small caps would likely fare best in the positive scenario.

Volatility will likely remain elevated as these issues continue to weigh on investors, in our view. Given positive policy resolution and our belief that stocks are reasonably valued, risk assets could provide attractive upside. Lack of positive resolution, on the other hand, would likely expose risk assets to further downside.


Rigorous stock selection. As always, we focus on innovation-driven, disruptive companies with strong management teams and bright futures. Our research shows that these businesses tend to generate earnings growth that not only outpaces most other companies, but also accelerates while doing so.

Active measures. Beginning in last year’s third quarter, we fine-tuned our portfolios to reduce downside risk and raise potential upside exposure. Key actions included:

  • Cutting the number of holdings to concentrate on our highest-conviction positions;
  • Exiting companies whose valuations surpassed their historical averages;
  • Reducing exposure to companies with significant non-US revenues; and
  • Trimming or selling positions in companies with high leverage.

As a result, our portfolios are well-positioned for an environment in which growth is scarce.

Opportunities. We’re reinvesting in securities we previously sold  when their valuations exceeded our price targets and are now appealing after selling off.

Favoring tech, health care, consumer and industrial companies. These sectors have compelling upside potential based on a combination of attractive valuations, strong demand and—for selected industrials—domestic orientation and high-quality balance sheets.

Healthcare: oversold. We’ve reviewed our healthcare portfolios for vulnerability to a possible decline in access to capital. Our companies are in good shape and sufficiently funded for at least the next 18 months. In addition, we see the sector—which has a high percentage of non-earnings generators that investors shun when they derisk—as oversold. Upcoming conferences and clinical trial readouts could catalyze support for companies that beat expectations.

Convertibles: portfolio repositioning. We’ve repositioned our convertibles portfolios much as we did with our equities, by reducing exposure to certain sectors with extended valuations as well as to companies with highly leveraged balance sheets and/or greater equity sensitivity. Convertibles could benefit from a potential rebound in smaller-cap companies (which dominate convertibles issuance).

This coming earnings season will be telling. As of this report, 2019 has gotten off to a strong start. We believe that the better relative valuations and earnings potential for small-cap stocks creates more opportunity, especially as growth becomes scarcer and thus commands more of a premium.



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